Explanation:
CVA (Credit Value Adjustment) is the expected loss due to the counterparty defaulting, which is driven by the counterparty's probability of default. DVA (Debit Value Adjustment) is the expected gain due to the entity's own default, driven by the entity's own probability of default.
Because the credit spreads for both Northern Star Bank and Horizon Financial Group have decreased, it indicates an improvement in their credit quality and a lower probability of default for both. A lower probability of default for NSB means its DVA will decrease. A lower probability of default for HFG means NSB's CVA (and conversely HFG's DVA) will also decrease. Thus, both CVA and DVA on both sides of the contract will be lower. Option C is correct.
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Q.4 In a recent transaction, Northern Star Bank (NSB) and Horizon Financial Group (HFG) entered into a 4-year interest rate swap. NSB agreed to pay HFG a fixed rate of 4.5% in exchange for 6-month SOFR plus a spread. Since the inception of the swap, both entities have experienced an improvement in their credit ratings. As a result, the credit spread for NSB has decreased from 90 bps to 40 bps, and the credit spread for HFG has decreased from 130 bps to 100 bps. Assuming the SOFR curve remains unchanged, which of the following statements is most likely to be correct if an identical 4-year swap was initiated today?
A
Since NSB's spread decreased more than HFG's spread, NSB's DVA will decrease and HFG's DVA will increase.
B
Since NSB's spread decreased more than HFG's spread, NSB's CVA will decrease and HFG's CVA will increase.
C
Since both entities' spreads decreased, the DVA and CVA on both sides of the contract will be lower.
D
Since both entities' spreads decreased, the DVA and CVA on both sides of the contract will be higher.
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